What If the Fed Does Taper QE? 8 Possible Scenarios

A look at the Fed's possible coming actions and the way they could affect the markets.

In previous articles and market overview reports, my firm discussed the unique macroeconomic position of gold (gold is a system hedge). The main conclusion was that gold is something else than its highly touted reputation as an inflation hedge. This realization is crucial for any gold investment decisions. Actually, when it comes to gold and the case for it or against it, there are many conflicting arguments. On one hand, we hear stories about the threat of inflation and a sharp rise of overall prices, therefore we're told that one should invest in this shiny asset. We also hear about credit deflation, banks in trouble, and financial markets that are not in great shape, making gold a good alternative. Having been fed all kinds of information, one can have trouble inferring what to do in various scenarios.

As always, there are many ways in which the situation can develop, and in today's article we will focus on what's probably the most important factor that will, to a great extent, determine what will happen in the coming months -- not just in the precious metals market, but also in bonds, stocks, and real estate markets.

Yes, you guessed correctly -- we are going to discuss the Fed's possible actions and the likely way this could affect the markets. Will we actually see any form of tapering or will we just hear about it? If so how will remarks made by the Fed impact actual events? As you know, very often what Ben Bernanke or some other Fed official says can ignite large price moves. So, for the analysis to be complete, we should focus not only on what happens, but also on how it is announced.

In the following part of this article we will discuss what's likely to happen if the Fed does indeed taper the QE program.

Based on the possible combinations, we created eight scenarios, and we will discuss how each of the markets (gold, stocks, bonds, real estate) could perform in each of them. We also explain which are the most and least likely. If they play out in the future you will already know what to expect in the following weeks/months.

The involvement of the Fed in buying assets makes it the most important player in the financial market. Over $3.5 trillion amounts to 23% of the American GDP (compare that to "savings," which are almost two times less than that). There are "rumors" about the Federal Reserve System's possible stepping back from its policy of quantitative easing. The rumors came from Bernanke's speech, and were slightly present in Fed's minutes from July 30-31 (the minutes were published on the August 21. They register discussions that take place during Federal Open Market Committee meetings).

The so-called tapering of the Fed would mean a significant slowdown of the programs (which lead to an increase in the assets holdings). Many observers argued that tapering is supposed to start before the end of 2013, September being the likely candidate. The minutes do not confirm this, at least not strongly. We can read that "almost all Committee members agreed that a change in the purchase program was not yet appropriate." There was only one mildly dissenting voice about some improvement in the labor market as a reason for the Committee to offer an explicit statement about asset purchase reduction in the "near future." A few members responded that patience is needed in order to carefully evaluate the economic data. A few others responded that the plan was already articulated (although not very strongly), and that the programs will be reduced.

In conclusion the Fed decided to keep the programs floating: They buy $40 billion of mortgage backed securities and $45 billion of Treasuries each month in order to bid the prices of both (and keep the returns low). Moreover, the interest rate is supposed to stay at the current low level of 0.25% as long as the unemployment rate stays below 6.5%, and the official inflation rate is not half a percentage point higher than the main policy goal of 2%.

What are the possible scenarios for the Fed? Most importantly, the so-called tapering can be significant, negligible, or nonexistent. It can be started because of optimism about the state of affairs, or pessimism because of ineffectiveness of the tools. It can also be done at different times. Moreover the Fed can offer different communications about the program.

We can think of various scenarios:

1. The Fed continues the programs and communicates to the public that not much has changed.

2. The Fed continues the program and communicates to the people that the program is being reduced because things are going great (economy is improving, unemployment is lower etc.).

3. The Fed continues the program and communicates to the people that the program is being reduced because of possible threats (e.g. inflation).

4. The Fed freezes the program and communicates to the people that things are going well.

5. The Fed freezes the program and communicates to the people that things are not very good (risk associated with the program are higher than benefits).

6. The Fed decides to reduce its holdings and communicates that things are going great.

7. The Fed reduces the holdings and communicates that it's because things are not going well.

8. The Fed will not change anything, but at the same time will think of something "special," perhaps some other tools. They can start some other programs instead of dealing with existing ones.

In today's article we will feature one of these scenarios in greater detail. Namely, we will discuss what would likely happen if the Fed froze the program and went into "standby" mode because of positive news. That's what corresponds to scenario No. 4 from the above list.

In scenarios No. 4 and No. 5, the Fed is moving to the standby position. It freezes its balance sheet, and decides to step back from continuous buying of securities, both governmental and mortgage. The communication in this case is the most important factor. In the fourth scenario the program is tapered, and the argument is made that the reason for this is that the economy has improved. The information is the following: The dollar system is in a better condition. Gold would probably go down under that scenario since it would lose parts of its appeal associated with its anti-dollar nature. The other markets would probably react positively in the medium term, especially Treasuries and the stock market.

It is also the case with real estate, but much less so. If the Fed stopped buying more mortgage securities, then leaving them in the market should lead to a downward pressure, right? Yes, but we have to accept that there are some small positive movements in the real estate. Probably not that definite, and we should still see a lot of things happening in the market. Nevertheless our decision to put an "upward pressure" comes from the fact that the Fed slowed down recently in the buying of commercial assets (at least if one compares the actions to the previous plans).

Therefore there is some paradox in the above table. We see more chances that real estate should grow under the freezing scenario than under the continuation scenario. Why? Simply put, if the Fed officially slows down its operations and communicates the case because of positives, then it may be a sign that there is some life in the real estate market (plus, standby means that government is ready to help at any time if things get worse). Whereas with the continuation program, an additional buying scenario, it will probably mean that there is much less life in the real estate, and the Fed is trying to continue a hopeless fight against market forces.

Summing up, what would likely happen if the Fed does indeed taper the QE program? Gold would likely suffer in the medium term, but other markets would likely thrive (even though no one can rule out a short-term upswing).

Matt Machaj, PhD, is an economist whose research is focused on the monetary policy, the gold standard, and alternative monetary regimes. Matt is a university professor, blogger, publicist, founder of the Polish Mises Institute branch, member of Property and Freedom Society, and laureate of Lawrence Fertig Award.